How to Save for Retirement: A Simple Guide to Achieve Your Dream

Most of us aren’t born knowing how to save for retirement. So here’s everything you need to know to simplify the process and help you succeed.
Last updated Sep 3, 2020 | By Miranda Marquit
How to Save for Retirement

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When it comes to planning for the future, Americans aren’t always the best at it — including when it comes to retirement.

In fact, according to a recent FinanceBuzz retirement survey, 21% of Americans haven’t even started saving for retirement. On top of that, 27% of Americans have seen their contributions derailed as a result of the COVID-19 pandemic.

Saving for retirement is a huge part of making sure you have what you need in the future. It’s important to get started and do it right if you plan to stop working someday. With all that in mind, here’s what you need to know about how to save for retirement.

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How to save for retirement

If you’re approaching retirement age or just thinking about the future, then you know saving for retirement is important. Figuring out how to save for retirement can feel overwhelming, though. But saving for retirement is actually as simple as these three steps:

  1. Have the right retirement accounts
  2. Take advantage of tax planning
  3. Cut your budget so you have more to save

Of course, simple doesn’t always mean easy, and there’s a little more to each step. But if you break each item down into even simpler, smaller steps, you’re more likely to be successful as you move forward in your efforts to save for retirement.

Let’s take a look at each of these three points in more detail to help you make the most of your retirement planning and saving.

Understanding where to save for retirement

Your first step is figuring out where to put your money. This means both knowing where to save and how to invest money. The right retirement savings accounts can help you reach your financial goals in a timely manner and make the most of every dollar. Here are some of the places you could put your money when saving for retirement.

Emergency fund and rainy day fund

Saving for retirement isn’t just about pensions and retirement funds, it’s also about having cash available for when things go awry. Your emergency fund and rainy day fund can help you avoid dipping into your tax-advantaged accounts when unexpected costs crop up. One of the biggest detriments to long-term retirement saving is pulling money out of your retirement accounts early.

For example, without an emergency fund, you might decide to withdraw money early from your retirement account. That could result in a penalty from the IRS — on top of a potentially bigger tax bill. Not only that, but the money is no longer earning compounding returns in your investment account. That opportunity cost could lead to financial problems down the road in your retirement.

Make sure you’re saving money for unexpected costs in savings accounts or taxable investment accounts that are accessible. A high-yield savings account can be good for these sorts of emergency funds. This way, you can cover expenses without drawing on your retirement accounts.

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401(k) plans

A 401(k) is a tax-advantaged retirement account typically offered by your employer. While you can only get a standard 401(k) through an employer, there is a solo 401(k) designed for self-employed business owners. So, if you own a business and you’re the only employee, you could potentially be eligible for a solo 401(k).

With a 401(k), you generally have money withheld from your paycheck and contributed to your retirement account. Many 401(k) plans offer a range of mutual fund investments you can choose from. You typically won’t make a lot of trades, although you can rebalance your retirement portfolio if needed.

Roth vs traditional 401(k)

There are different tax treatments when it comes to contributions. With a traditional 401(k), you make contributions with pre-tax money. Your employer takes the money out of your paycheck before income taxes are figured. As a result, you get a tax break today. However, later, when you withdraw money from your account, the amount you take out will be subject to taxation as ordinary income.

On the other hand, there’s also the possibility of having a Roth 401(k), depending on your employer. If your employer offers this option, you can make 401(k) contributions with after-tax money. So, you’re taxed on the contributions today, but your investments grow tax-free. During retirement, when you take your distributions, you won’t have to pay taxes.

When thinking about whether to make Roth 401(k) vs. traditional 401(k) contributions, consider if your taxes might be higher now or later. If you think your tax bill is likely to be higher during retirement, it can make sense to make Roth contributions. However, it’s possible to make a combination, taking advantage of both traditional and Roth contributions.

401(k) contribution limits

Each year, the IRS reviews inflation and other factors to determine contribution limits to tax-advantaged accounts. For 2020, the 401(k) contribution limits are $19,500, plus another $6,500 in catch-up contributions if you’re at least 50 years old.

Don’t forget about the 401(k) match

If your employer offers a matching contribution, it can make sense to take advantage of it. Basically, your employer provides you with free money that grows over time with compounding returns. This can be a powerful way to boost your retirement savings.

For example, if your employer matches 50% of your contribution up to 6% of your income, you could see a nice boost, even if all you do is take full advantage of your match. Say you receive $2,500 with each paycheck. Six percent of your income amounts to $150. That’s how much you put in. Your employer will then also put in $75, or 50% of what you contribute. If you’re paid twice each month, you’re putting in $300 a month toward retirement and getting an extra $150 a month from your employer. That amounts to an extra $1,800 a year from your company. That’s not too shabby and can make a big difference down the road if that money is invested.

Realize, though, that your employer’s matching contributions are always put into a traditional 401(k). So, even if you’re making Roth contributions, the amount your employer contributes will actually go into a traditional account. This can be one way to take advantage of both types of contributions. If you’re unsure what this means for your personal finances, speak with a tax professional to see what the potential implications might be.

IRA plans

As you consider how to save for retirement, including individual retirement accounts (IRAs) can be an important part of moving forward. With an IRA, you choose where you want to hold your money. So, you could choose a financial institution you’re already comfortable with or a totally different broker that offers the types of investments you want.

In general, an IRA is more flexible. You can hold individual stocks and bonds in an IRA, as well as mutual funds and ETFs. Additionally, depending on your custodian, you might even be able to hold some businesses, real estate, and certain precious metals in an IRA.

Roth vs traditional IRA

You can make Roth IRA contributions when saving for retirement, but it’s important to understand the limits that come with Roth IRAs. The main issue is that you have to meet income criteria. Once you reach a certain annual income threshold, you can’t make contributions to a Roth IRA.

However, you may still be able to make tax-deductible contributions to a traditional IRA, as long as certain conditions are met. Your ability to take advantage of the tax benefits of a traditional IRA will also depend on your income as well as whether you (or your spouse) has access to a 401(k) plan at work.

IRA contribution limits

IRA contributions limits, like 401(k) limits, are set by the IRS each year. However, contribution limits for IRAs are much lower. In 2020, the contribution limit is $6,000, with an additional $1,000 catch-up contribution for those who are 50 years and older. However, there are different contribution limits if you have a SEP IRA (up to $57,000) or a SIMPLE IRA ($13,500).

Other types of IRAs

If you don’t feel that a “regular” IRA will get you to your retirement goals, here are some other types of IRAs:

  • SEP IRA: Traditional IRA (no Roth option) that allows small business owners and the self-employed to save for retirement with higher limits.
  • SIMPLE IRA: A tax-deferred savings plan you can institute as a business owner. It allows you and your employees to save for retirement.
  • Spousal IRA: If you have a spouse who doesn’t work, they can open an IRA in their name, and you can make contributions to their account.

Self-employed retirement plans

Even if you’re self-employed, it’s possible to set aside money for retirement. While you can use an IRA if you’re self-employed, you might not be able to save as much as you’d like. This is where you can take advantage of the solo 401(k), SEP IRA, or SIMPLE IRA. With these self-employed retirement plans, there are options to fit most business situations and savings goals.

The importance of tax planning in saving for retirement

When saving for retirement, tax planning is essential. While there’s no way to know exactly what will happen, giving some thought to your tax situation today and your likely tax situation in the future can help you make better decisions with your retirement dollars.

Traditional vs. Roth accounts

Your first consideration is whether to make traditional or Roth contributions to your retirement savings accounts. The main difference comes with how your money grows:

  • Roth contributions are made with after-tax dollars. As a result, your investments grow tax-free. Later, when you take money out of your account, you don’t pay taxes on your withdrawals.
  • Traditional contributions are made with pre-tax money. You get a tax break today, and your money grows tax-deferred. However, when you take distributions from your account later, you’ll have to pay taxes on the money at your regular tax rate.

In general, the advantage to Roth contributions is that you don’t have to worry about paying taxes down the road. You can withdraw as much money as you want, without concerns about the tax bill. The downside is you won’t get a tax break today. So, if you want a lower tax bill today, a Roth account won’t help you.

On the other hand, with a traditional account, you see a lower tax bill today and more money in your pocket right now. The downside is, if your tax rate is higher in the future, you will have to pay more on the money you withdraw during retirement than you would today.

For some savers, it makes sense to make Roth contributions while they have a lower income, say at their very first or second job. You’re likely to have a lower tax bill when you’re a long way out from retirement and early on in your career, so paying taxes on your contributions is not a huge deal. Later, as your income increases and you end up in a higher tax bracket, it might make sense to switch to traditional contributions.

In truth, you don’t have to choose one or the other. It’s possible to use both types of accounts to improve your overall tax efficiency in retirement. You may consider speaking with a tax professional or retirement specialist about the tax implications of Roth and traditional accounts, as well as how to plan out your withdrawals from your accounts and how to coordinate them with your expected Social Security benefits.

Understanding the rollover strategy

Just because you chose one account doesn’t mean you’re stuck with it. You can actually roll your money strategically from one account to another based on a retirement plan you’ve worked out or just because you’ve changed your plan.

In general, the simplest rollover strategy is just to make sure your tax treatment matches. So, you might roll a traditional 401(k) into a traditional IRA, or a Roth 401(k) into a Roth IRA. If the tax treatment on your accounts is different, and you’ve already received a tax advantage from your traditional contributions, you might have to pay taxes on some of the money you move. Make sure you consult a tax professional before moving money from a traditional to a Roth account.

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The role of taxable accounts

If you’ve maxed out your 401(k) and IRA or simply want to diversify your savings, you might consider investing in a brokerage account. In this case, you use a taxable account to continue growing your wealth. On the plus side, you have more access to your money, since you don’t have to worry about the 10% penalty for early withdrawals like you do with most retirement accounts.

You can open a taxable account with a traditional or online brokerage, or use a robo advisor or investment app to get started. For example, I have taxable accounts with Acorns and M1 Finance to help me meet other goals, as well as to ensure I have access to penalty-free money prior to age 59 1/2. I’ve also used Betterment in the past to meet various personal finance goals with a taxable investment account.

Realize, though, that you’re subject to capital gains tax on your earnings with these accounts. There’s a lower rate for long-term capital gains on investments you’ve held for more than a year. Short-term gains, though, are taxed at your marginal rate.

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How to cut your budget and save more money

Part of being able to put money aside now and also live on a fixed income in the future means being able to live on a budget. There are a lot of easy ways to save money — here are a few ideas.

Trim your bills

One of the best ways to reduce your costs is to review your bills and look for ways to save. For example, you might be able to save money on utilities by switching your provider. Additionally, there are services like Truebill that help you reduce your cable, phone, and internet expenses. Look for ways to reduce your monthly costs, and put the savings in your retirement account.

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Use cashback apps

Rather than always cutting costs, you can also get a little extra cash back on purchases you’d make anyway. There are several cashback apps that can provide you with a way to get money on planned purchases. Paribus, Fetch, and Ibotta are just a few of the cashback apps that can help you boost your retirement savings.

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Pay off your debt

Another way to cut your budget is to reduce your debt. The interest you pay on debt reduces the amount of money you have that could be going toward retirement. Make a plan to have all your credit card debt and other debts paid off by the time you retire.

Some strategies you can use to pay down your debt include:

  • Debt consolidation: Consolidate your debts in one place with a loan that pays off your smaller debts. If you can get a lower interest rate, you may save on payments and interest and get out of debt faster.
  • Balance transfer credit cards: If you can find a 0% APR balance transfer credit card, you can really tackle your debt. When you aren’t paying interest, you end up able to reduce your debt faster and save money in the long run.
  • Debt snowball or debt avalanche: These strategies help you order your debts in a way that allows you to tackle them with a manageable strategy. With the debt snowball method, you focus on your lowest balance first, putting extra payments toward one loan while maintaining the minimum on other accounts. The debt avalanche method uses the same concept, but you start with the highest-interest debt.

No matter how you go about it, the important thing is that you reduce your debt and get in a position to put that money toward retirement.

Bottom line

Social Security benefits are not likely to be enough for you to live your target retirement lifestyle. Instead, you need to learn how to save for retirement using other methods. Talk to a tax professional and/or a financial advisor to help you formulate your retirement savings plan, and then stick to it to build a comfortable nest egg over time.

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